Economic policy for an imperfect world.

• Author: Vaughn, Karen I.

1. Introduction

   It has been four years since the total collapse of even the pretense of central planning in the former Soviet Union. Since that time, there has been almost universal agreement among the nations of the world that market economies are necessary for the production of wealth. The mounting problems of the highly bureaucratic and rigid Soviet economy in the last decade of its existence are now common knowledge. Pundits who once feared the economic "superiority" of a centrally planned Soviet system now seem to be counting the days until even a die-hard like Fidel Castro bows to the inevitable and agrees to reform the Cuban economy. Yet those who would take this turn of event to mean that the case for "the free market" is now "won" are declaring victory prematurely. While to be sure, almost no one of any stature still holds out hope for total central planning, the alternative that is considered is not "free markets" so much as a regulated market economy. That is, most of the countries undergoing transition to market economies are searching for the appropriate rules and policies to avoid the excesses of capitalist development, and they are looking toward Western style welfare and regulatory states for guidance. Meanwhile, many of the European welfare states, which are facing problems of increasing public expenditures, stagnating economies, and high unemployment are themselves beginning to reexamine the question of the right mix of government and market. And in the United States, the forces supporting more market and less government are increasingly making their voices heard on the political scene.

   The question I want to explore here is the following: what role can conventional neoclassical economic theory play in helping to inform this historic moment? As political regimes world wide are struggling to find the appropriate role for the market in the political order, or conversely, the appropriate role for government in a market order, what can contemporary economic theory contribute to the debate?

   This may seem a ridiculous question to most of you. Obviously, economists using standard economic theory are continually participating in policy formation at home and abroad. There is a veritable flood of economic advisors to formerly communist countries helping them to install market economies. Here at home, regiments of policy analysts, think tank dwellers, advisors to political parties, congressional committees, and presidential panels continually pronounce on things economic. Regulatory agencies are especially blessed in this department. But my question isn't whether they do it, it is on what basis do they do it. What standards are they applying to inform policy? What is the scientific status of the policy recommendations made? What can economic theory tell us about the role of government in the economy?

   This is not an idle question. More than a decade ago, Frank Hahn [12] argued that general equilibrium theory tells us that the invisible hand needs a visible assist from government to keep it from paralysis. More recently, Joseph Stiglitz [29] has argued that there is no scientific argument to support a belief that free markets work. Those who advocate them do so out of an ideological commitment. If we consider also recent "revisionist" work on two policy areas in which economists once were in overwhelming agreement: Card and Kreuger [6] who argue that minimum wages do not necessarily reduce employment, and Richard Arnott [2] who argues that well designed rent control may bring about good economic effects, it is clear that the question of what theory informs economic policy is important.

   My argument will be as follows: The rational for most economic policy is the enhancement of economic efficiency. Yet our definition of efficiency is based on equilibrium models of perfect markets, and there is the rub. Perfect market models serve less to explain how markets work than to identify imperfections in economic order that interfere with the achievement of perfectly efficient outcomes. These imperfections, in turn, appear to be ripe for some policy intervention. But to go from an equilibrium model of a perfect market to real world imperfections to policy correctives requires several leaps of logic that call the whole exercise into question. We must presume first that the model is sufficient to identify the ideal state, second that the imperfections are correctable and third that a policy even in principle can be designed to eliminate the imperfection. None of these steps is unproblematic. In fact, I argue that our models are not sufficient to identify an ideal state of the world. Even if they were, it is not clear that any policy we are able to devise could bring it about. Finally, those features of the real world we call imperfections are often integral parts of a market process that we are only beginning to understand.

2. The Theoretical Basis for Economic Policy Formation

   For most of the twentieth century, economic theory has been dominated by one or the other of two related models: Perfect competition, both the mainstay of partial equilibrium analysis and a necessary condition for the achievement of the second, more encompassing market model: general equilibrium.(1) Perfect competition is perfect because in equilibrium, production is perfectly efficient: prices equal marginal costs, goods are produced at minimum average cost and economic profits are zero. These equilibrium conditions guarantee that there is no way to reorganize production to get more of the good at a price consumers will pay. General Equilibrium is perfect in a related but more stringent sense that all markets are in perfectly competitive equilibrium such that no improvement in the entire economic system is capable of being made.

   It is often maintained that the economic case for unrestricted markets is based on these models of perfect competition and general equilibrium. But if these models are the sole defense of free markets, the defense is a poor one at best. Quick examination reveals that these models do not support the contention that unrestricted market competition within a set of minimal rules results in efficient outcomes. Instead, they offer more support for a regulated market economy. The same theory that describes the efficient nature of perfect competition also suggests that in many, perhaps even most, instances perfect competition doesn't apply. And if one takes a general equilibrium view of market economies, it is clear that full equilibrium could never be obtained by a free market. The reason is the widespread existence of market imperfections such as monopoly power, imperfect information, incomplete markets and externalities that all lead to market failure.

   Let us dwell for a moment on the rhetorical impact of the term "market failure." "Market failure" sounds very ominous indeed. It seems to conjure up a devastating flaw with dire consequences - perhaps like brake failure or heart failure. More accurately, however, market failure simply means some condition of market exchange that prevents achievement of full equilibrium as described by an abstract model. Any identified "market failure" says nothing about the overall strength of competitive forces, nor the overall health of the economy. While it seems to be the case that real economies manage to chug along quite productively despite the presence of as myriad of imperfections, we don't seem to have a theoretical language to explain such real world robustness in the face of putative market failure, although economists often argue about the practical seriousness of one market failure or another. Indeed, an economist's political views are largely a consequence of how important a factor s/he believes market failure to be in real economic affairs.(2)

   But whether one believes that market failures are important and widespread as do tbe New Keynesians, or that they are of small consequence in a typical market economy as do Chicago economists, the fact remains that market failure to most economists suggests a defect in the market place that at least in principal could benefit from some well designed government intervention. But can we legitimately go from identifying market failures to making a case for government policy in one logical leap? Given the nature of our economic models and the limitations of our knowledge about market entities, the leap is at the very least, suspect. It may or may not be the case that markets will work better when government takes on a regulatory role: But simple identification of market failure is not sufficient to establish the case.

3. The Public Choice View

   You will all remind me that I am not the first one to make this point. Since the 1960s and the publication of the Calculus of Consent [s], it is inexcusable, and increasingly unlikely, for an economist to blithely advocate regulatory policy without taking into account the problem of "government failure," the inability of government to develop policies that satisfy voters' preferences. Public choice economics, by applying the same model of human action used in economics to political decision making shows that policy formation is far more complicated than the "there oughta be a law" sentiment suggests. This body of literature has analyzed the ways in which democratic governmental processes involve a variety of motives that belie an easy path to correcting market failures [21]. There are unintended consequences both in the formation and in the execution of economic policy. Factors such as interest group politics in the design of policy, and the need to implement policy via a bureaucracy that follows its own rules and encompasses a variety of conflicting agendas lead us to be wary of calling for more market correctives than the political system can effectively...